Since housing prices have dropped, I've been getting more and more inquiries from homeowners about whether they should lower the amount they insure their home for.  Great question.

The price that most homeowners see going down is the market value of their home.  The 'market' value of the home is really the value the house and land together can fetch if it were sold to a buyer on the open market.

On your insurance policy, your home is normally insured to its replacement cost.  This price is considered to be the amount it would cost to rebuild the home if it were to burn down to the ground.  Remember, home insurance does NOT insure the land, only the structure.

So as you can see, market value can be dramatically different from replacement cost, or the amount it would cost to rebuild the house.

A good example of the difference between market value and replacement cost is this: 

Take an average 2500 square foot home in Any-City, USA.  The market value of this home in Any-City is $350,000.  The replacement cost for this home is calculated to be $200,000. 
Now, imagine that same home being located in Any-Rural, USA.  The market value of that same home may now only be $250,000, but the replacement cost will remain the same at $200,000 because it would cost essentially the same to rebuild the home in a rural area.

So regardless of market value, if your insurance agent set your policy up correctly when you bought the insurance policy, you shouldn't need to reduce the insured amount of the home.  There are exceptions to this, so seek the advice of your insurance professional to address your unique situation.